Currency Futures Introduction and Example. FuturesDaniels and VanHoose2 Currency Futures A...

Currency Futures

Introduction and Example

Futures Daniels and VanHoose 2

Currency Futures

• A derivative instrument.

• Traded on centralized exchanges (illustrated in Figure 1 later).

• Highly standardized contracts.

• Clearinghouse as counter-party.

• High leverage instrument.


Currency Futures

• Initial Margin: The customer must put up funds to guarantee the fulfillment of the contract - cash, letter of credit, Treasuries.

• Maintenance Margin: The minimum amount the margin account can fall to.

• Mark-to-the-market: A daily settlement procedure that marks profits or losses incurred on the futures to the customer’s margin account.


Sample Bond Performance RequirementsFrom the CME, 15 March 2000

Currency Futures Initial MaintenanceAustralian Dollar $1,317 $975British Pound $1,620 $1,200Canadian Dollar $642 $475Deutsche Mark $1,249 $925Euro $2,430 $1,800


Long and Short Exposures

• A person that is, for example, long the pound, has pound denominated assets that exceed in value their pound denominated liabilities.

• A person that is short the pound, has pound denominated liabilities that exceed in value their pound denominated assets.


Hedging With a Currency Future• To hedge a foreign exchange exposure, the

customer assumes a position in the opposite direction of the exposure.

• For example, if the customer is long the pound, they would short the futures market.

• A customer that is long in the futures market is betting on an increase in the value of the currency, whereas with a short position they are betting on a decrease in the value of the currency.

How an Order is Executed (Figure from the CME)


Example

A US manufacturing company has a division that operates in Mexico. At the end of June the parent company anticipates that the foreign division will have profits of 4 million Mexican pesos (MP) to repatriate.

The parent company has a foreign exchange exposure, as the dollar value of the profits will rise and fall with changes in the exchange value between the MP and the dollar.


Example, continued

• The firm is long the peso, so to hedge the exposure they will go short in the futures market.

• The face amount of each peso future contract is MP500,000, so the firm will go short 8 contracts.

• If the peso depreciates, the dollar value of the division’s profits falls, but the future account generates profits, at least partially offsetting the loss. The opposite holds for an appreciation of the peso.

Change spot value

Change in futures price

Gain

Loss

Underlying Long Position

Futures Position


Example, continued

• The previous diagram illustrates the effect of a change in the value of the peso.

• An increase in the value of the peso increases the dollar value of the underlying long position and decreases the value of the futures position.

• A decrease in the value of the peso decreases the value of the underlying position and increases the value of the futures position.


Example, continued

• On the 25th, the spot rate opens at 0.10660 ($/MP) while the price on a MP future opens at 0.10310.

• The market closes at 0.10635 and 0.10258 respectively.

• The loss on the underlying position is:• (0.10635-0.10660)MP4 mil. = -$1,000• The gain on the futures position is:• (0.10310-0.10258)8MP500,000=$2,080

Change spot value


Gain

Loss

Underlying Long PositionMP4 million

Futures PositionMP500,000 x 8

-0.00025

-0.00052

$1,000

$2,080

Gain and Loss on Underlying and Futures PositionDay 1


Example, continued

• On the 28th, the spot rate moves to 0.10670 ($/MP) and the price on a MP future to 0.10285.

• The gain on the underlying position is:• (0.10670-0.10635)MP4 mil. = $1,400

• The loss on the futures position is:• (0.10258-0.10285)8MP500,000=-$1,080

Change spot value


Gain

Loss



$1,080

$1,400

0.00035

0.00032



Example, continued

• On the 29th, the spot rate moves to 0.10680 ($/MP) and the price on a MP future to 0.10290.

• The gain on the underlying position is:• (0.10680-0.10670)MP4 mil. = $400

• The loss on the futures position is:• (0.10285-0.10290)8MP500,000=-$200

Change spot value


Gain

Loss



$200

$400

0.00005

0.0001



Example, continued• For the three days considered, the underlying position

gained $800 in value and the futures contracts yielded $800.

• The hedge was not perfect as the daily losses on the futures were less than the gains on the underlying position (day 2 and 3), and the daily gains on the futures exceeded the losses on the underlying position (day 1).

• In this example, the imperfect hedge yielded additional gains.


Example, continued

• Suppose you wanted to close the futures position (without making delivery of the currency).

• The position is simply reversed. That is, you would go long 8 MP futures, reversing your current position and closing out your account.


Additional Information

For additional information on currency futures, visit the following sites:

• The Chicago Mercantile exchange at www.cme.com.

• The Futures Industry Institute at www.fiafii.orb.

Currency OptionsCurrency Options


Currency Options

• A currency option is a contract that gives the owner the right, but not the obligation, to buy or sell a currency at a specified price at or during a given time.

• Call Option: An option that gives the owner the right to buy a currency.

• Put Option: An option that gives the owner the right to sell a currency.


Currency Options

• American Option: An option that can be exercised any time before or on the expiration date.

• European Option: An option that can only be exercised on the expiration date.


Currency Options

• Exercise or Strike Price: The price (spot exchange rate) at which the option may be exercised.

• Option Premium: The amount that must be paid to purchase the option contract.

• Break-Even: The point at which exercising the option exactly matches the premium paid.


Currency Options

• If the spot rate has not yet reached the exercise price, the option cannot be exercised and is said to be “out of the money.”

• If the spot rate equals the exercise prices, the option is said to be “at the money.”

• If the spot rate has surpassed the exercise price, the option is said to be “in of the money.”


Call Option

• The holder of a call option expects the underlying currency to appreciate in value.

• Consider 4 call options on the euro, with a strike of 92 ($/€) and a premium of 0.94 (both cents per unit).

• The face amount of a euro option is €62,500.• The total premium is:

$0.0094·4·€62,500=$2,350.

Profit

Loss

88.15

92 92.94

93.5

Payoff Profile

Spot Rate

-$2,350

-$1,100

0

$1,400

Out-of-the-money At In-the-money

Call Option: Hypothetical Pay-Off

92.5Break-Even


Put Option

• The holder of a put option expects the underlying currency to depreciate in value.

• Consider 8 put options on the euro with a strike of 90 ($/€) and a premium of 1.95 (both cents per unit).

• The face amount of a euro option is €62,500.• The total premium is:

$0.0195·8·€62,500=$9,750.

Profit

Loss

88.05 90

Payoff Profile

Spot Rate

-$9,750

-$5000

In-the-money At Out-of-the-money

Put Option: Hypothetical payoff at a spot rate of 88.15

88.15

Break-Even

Currency SwapsCurrency Swaps


Introduction

• A currency swap is an agreement between two parties to exchange a given amount of one currency for another, or a stream of payments or receipts in one currency for a stream of payments or receipts in another currency.

• Currency swaps, in contrast to interest rate swaps, typically involve an exchange of principle.

• A cross-currency swap involves the additional exchange of a floating interest rate for a fixed rate.


Purpose

• A currency swap allows a firm to lock in the domestic currency value of a debt issue or future receipt.

• It can allow a firm access to more favorable loan conditions.


Difference with Forward

• A forward contract could be used to accomplish the same thing as a swap.

• As opposed to forwards, swaps usually involve the immediate matching of two counter parties with opposite needs, or a double coincidence of wants.

• Long-dated forwards, therefore, tend to be much more costly to the firm.


Example

Consider the following example: A US firm wants to borrow euros to finance a project in Europe. The firm is not well know in the foreign markets. Higher information costs translate into higher financing costs. Hence, the firm finds it cheaper to borrow dollars in the domestic market.


Example

• At the same time, a European firm is in need of dollar financing.

• An intermediary (or swap dealer) can arrange a swap between the two firms.

• Each firm borrows in their own home market—presenting the respective home market with a well-know identity versus and unknown identity—thereby reducing the cost of funds to each firm.


Solution

• The US firm issues dollar-denominated debt in the US market, while the European firm issues euro-denominated debt in the European market.

• Using the proceeds from the debt issues, the two firms swap the dollar principal for an equivalent euro principal.


Solution

• The US firm makes periodic euro payments to the dealer in exchange for an agreed amount of dollars. The dollars are used to pay interest to US bondholders.

• The European firm makes periodic dollar payments to the dealer in exchange for an agreed amount of euros. The euros are used to pay interest to the European bondholders.


Solution – The US Firm

• At the end of the maturity period, the US firm pays euro-denominated principal to the dealer in exchange for the dollar equivalent.

• The dollar funds received from the dealer are used to repay the principal to the bondholders.

• The initial inflow and subsequent outflows of the firm replicate euro denominated debt, but at a lower cost.


Illustration – US Firm

• Note that the swap has two branches: One between the US firm and the dealer and another between the European firm and the dealer.

• The swap, from the perspective of the US firm is illustrated in the next slide.

40Daniels and VanHooseFutures

Dealer

Firm

Bondholders

$ principal

$ principal

€ equivalent

Dealer

Firm Firm Firm

Dealer Dealer

Bondholders Bondholders Bondholders

$ interest

€ payment

$ payment

€ payment

$ payment

$ interest

€ principal

$ equivalent

$ principal

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